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Business services matter more than manufacturing

One of the hardest adjustments for anyone thinking about the economy – economists included – is to adjust their mental model as the economy evolves. We’re all prone to think about the economy we grew up with, instead of the one we have now.

Back in the 1800s, agriculture was half of Australia’s economy. Now it’s less than 3% – and yet we have one of the largest agricultural production surpluses in the world. If we had a way to convey this news to the commercial minds of the late 1800s, they would fall out of their Victorian armchairs.

The same thing has happened in manufacturing, which moved from 15% to 7% of the market economy in the quarter-century or so after 1990. Australia’s 2016 manufacturing production actually grew over that time.

But we now know how to make a given amount of manufactured goods using far less of our economic resources. And, after adjusting for inflation, manufactured goods are now much cheaper than they were in 1990 – something you’ve probably noticed if you’ve shopped for a car recently. The result: A shrinking proportion of our money goes to manufactured goods.

If you’re part of the generations that came of age before 1990, your mental take of Australia’s economy may not reflect all of this. You may instead have absorbed the lesson that manufacturing was the only way to national prosperity. And, in the late ’50s, it almost was.

So, former Australian PM Kevin Rudd, born in 1957, famously declared that he didn’t want to live in a country that didn’t make things. He was following an instinct formed in a different era, mouthing a sentiment his parents probably would have agreed with.

Another way of looking at this is that there’s only so much stuff we can buy. Past a certain national average income, people want more and more to spend their money on improving themselves and having enjoyable experiences. In a speech earlier this month, Alexandra Heath, head of economic analysis at the Reserve Bank of Australia, put it this way: “As incomes rise, households typically spend more of their income on household services, such as health, education and restaurant meals, than on goods.

As Heath pointed out, another thing is happening too: Businesses of all types are buying in services from outside providers. The business services sector, less than 20% of the economy in 1990, has now topped 25%. Indeed, as a share of the economy, the business services sector is now more important than the goods production sector, which includes not only manufacturing but also mining, utilities (like electricity and water) and construction. It’s a big turnaround in a short time.

Figure 1: The rise of business services

Industry gross value added, per cent

Excludes agriculture, forestry and fishing, public administration and safety, and ownership of dwellings<br /> Source: ABS, RBA

‘Business services’ is a clunky phrase for a huge collection of different tasks, from organising a BHP takeover to emptying office rubbish bins; from engineering and legal work to programming, event management and management consultancy. And, of course, business finance looms large.

One factor boosting the sector’s importance is businesses’ desire to shed non-core activities. Increasingly, businesses can take advantage of internet-based systems to link themselves to external firms and global services.

The RBA is trying to understand this sector better, because it suspects the business services industries are important to explaining how Australia copes with technological change.

My bet is that Heath and her colleagues are right to look here. These days, if you want to find a prosperous country, region or city, you don’t look either for big agricultural producers or centres of manufacturing. You ask where the business services firms are clustering.

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